Chapter 3

Interdependence and
the Gains from Trade
Interdependence and Trade

Remember, economics is the

study of how societies produce
and distribute goods in an
attempt to satisfy the wants and
needs of its members.
How do we satisfy our wants and needs
in a global economy?
 We can be
economically self-
sufficient.
 We can specialize and
trade with others,
leading to economic
interdependence (I.e.
Globalization)
A Parable for the Modern Economy

 Imagine . . .
only two goods: potatoes and meat
only two people: a potato farmer and
a cattle rancher
 What should each produce?
 Why should they trade?
 The Production Opportunities of the
Farmer and the Rancher

Hours Needed to Make 1 lb. of: Amount Produced in 40 Hours

Meat Potatoes Meat Potatoes
Farmer 20 hours/lb 10 hours/lb 2 lbs. 4 lbs.
Rancher 1 hours/lb 8 hours/lb. 40 lbs. 5 lbs.
Production Possibilities Frontiers
Meat
(pounds) (a) The Farmer’s Production
Possibilities Frontier

2
A
1

0 2 4 Potatoes (pounds)
 Meat 40
(pounds)
Production Possibilities Frontiers
(b) The Rancher’s Production
Possibilities Frontier

20 B

0 2.5 5 Potatoes (pounds)

The Gains from Trade: A Summary

The Outcome
Without Trade:
What They Produce
and Consume
1 lb meat (A)
Farmer 2 lbs potatoes
20 lbs meat (B)
Rancher 2.5 lbs potatoes
 The Gains from Trade: A Summary

The Outcome
With Trade:
What They What They What They
Produce Trade Consume
0 lbs meat Gets 3 lbs meat 3 lbs meat (A*)
Farmer 4 lbs potatoes for 1 lb potatoes 3 lbs potatoes
24 lbs meat Gives 3 lbs meat 21 lbs meat (B*)
Rancher 2 lbs potatoes for 1 lb potatoes 3 lbs potatoes
Trade Expands the Set of Consumption
Possibilities
Meat (a) How Trade Increases the
(pounds) Farmer’s Consumption
Farmer’s
A* consumption
3 with trade

2 Farmer’s
consumption
A without trade
1

0 2 3 4 Potatoes (pounds)
 Trade Expands the Set of Consumption
Meat 40 Possibilities
(pounds)
(b) How Trade Increases The
Rancher’s Consumption
Rancher’s
21 B* consumption
20 with trade
B
Rancher’s
consumption
without trade

0 2.5 3 5 Potatoes (pounds)

The Gains from Trade: A Summary
The Gains
From Trade:
The Increase in
Consumption
2 lbs meat (A*- A)
Farmer 1 lb potatoes
1 lb meat (B*- B)
Rancher 1/2 lb potatoes
The Farmer and the Rancher
Specialize and Trade
Each would be better off if they
specialized in producing the product, they
are more suited to produce, and then
trade with each other.
 The farmer should produce potatoes.
 The rancher should produce meat.
The Principle of
Comparative Advantage
Differences in the costs of
production determine the following:
 Who should produce what?
 How much should be traded for each
product?

Who can produce potatoes at a lower

cost--the farmer or the rancher?
Absolute Advantage
 Describes the productivity of one person,
firm, or nation compared to that of another.
 Absolute advantage can be measured in
two ways:
 Least number of hours to produce a good.
 Most number of goods produced in a given
amount of time.
Comparative Advantage
 Compares producers of a good
according to their opportunity cost.

 The producer who has the smaller

opportunity cost of producing a
good is said to have a comparative
advantage in producing that good.
The Opportunity Cost of Meat and Potatoes
1 pound of 1 pound of
meat potatoes

Farmer 2 pounds of 1/2 pound of

potatoes meat

Rancher 1/8 pounds of 8 pounds of

potatoes meat
Should Tiger Woods Mow His Own Lawn?

?
? ?
What are the pros and cons of
Globalization?
Globalization means
that free trade is
spread to all corners
of the world with no
hindrances.
Globalization Video